Emerging Manager Series: Advantage Capital

In the past we have interviewed a number of emerging hedge fund managers whose strategy and style of investment we particularly respect. In the latest edition of our emerging manager series, we caught up with Irv Schlussel of Advantage Capital. Irv launched Advantage in December of 2013 after two successful years managing an account at Telemus Capital. More information on Advantage Capital can be found on their website advantagecapm.com

Enjoy and have a wonderful Thanksgiving!

You started your career in equity research, how did you find yourself in distressed debt investing?

I began developing my interest in the distressed space when I was in college. The idea of investing in a situation where there was significant confusion and forced selling was quite appealing to me. I read the book “The Vulture Investors” by Hilary Rosenberg and then did a summer internship at the distressed firm Wexford Capital. After working at Wexford, I was sold and directed my career toward distressed. The distressed market has developed significantly from the 1980s and early 1990s, when investors purchased loans directly from the workout groups of commercial banks, but there continues to be significant opportunity in the space. When I graduated from Wharton in the early 2000s, the traditional path was to work in banking research or trading. UBS had an excellent training program, and working there helped me gain perspective prior to going to the buy-side and into distressed investing.

Perhaps consequently, your fund’s investments involve a combination of equity and debt investments. How does that help when special situations opportunities are sparse?

I think it is critical to have the flexibility to move across the capital structure and adapt to the opportunities that are available in varying market environments. Many of the core analytical and legal skills used in distressed can be applied to merger arbitrage and other litigation related opportunities. Even within a distressed capital structure, we sometimes find that having a smaller sized position in the equity results in a more asymmetric return profile when compared to investing in the debt. We focus our analysis on finding the most optimal positioning within a given capital structure and this has been a key component of the fund’s success thus far.

Your portfolio has a mix of hedged/arbitrage trades and directional fundamental positions, can you describe your criteria for using one or the other?

We think having a mix of outright and hedged positions is the key to successful portfolio management. We find it safer to deploy capital when we can identify a great hedge within a capital structure. In such a scenario, we focus our research on the catalysts that will make our trade work. We perform extensive fundamental research, but the hedged nature of our risk gives us greater flexibility in how we can size the position. We also develop a good sense of the time horizon of an event that will catalyze these hedged positions.

A good example of an appealing hedged opportunity was the merger arbitrage in the pre-chapter equity of the then bankrupt American Airlines. American was emerging from bankruptcy through a merger with US Airways. AAMRQ had sold off disproportionately to the value of new shares of US airways into which it would be converted. There was significant confusion in the market as holders of the then bankrupt AAMRQ were to receive the majority of their stock in the NewCo (AAL) over a period of four months. During this period, the AAMRQ stock would be delisted and cease trading. News of the delisting caused forced selling by many market participants who were not allowed to own delisted companies. We seized upon this opportunity to put on a hedged arbitrage position in which we bought AAMRQ and sold short AAL to reduce our risk. The merger spread on this position was in the mid-teens on a non-annualized basis and the weighted average time to close was about two months given the timing of distributions.       

Outright positions are usually driven by a significant mismatch between our perceived value of a security and the prevailing market price. When we have done significant work and believe we have an informational advantage, we are comfortable having directional risk in a given situation.

In the last three years when you’ve seen mega-funds take huge hits on situations such as the government sponsored enterprises and then have been stagnated in other investments due to a slow distressed market, Advantage has posted significant double digit returns ahead of the HFRI distressed and event driven indices. What has set your firm apart?

We think one of our strengths is the management of position sizing in some of the crowded distressed trades. We have a position in FNMA and continue to be favorable on the GSEs. We are more likely to take larger positions (7-10% of capital) in situations like Genco, GT Advanced Technologies, Verso, Syncora & YRCW. These situations are less crowded and we believe our involvement through participation on the committees and positioning in the information flow allows us to have an advantage.

You’ve been bearish on the corporate debt market while emphasizing “opportunities in idiosyncratic situations” that give rise to investments that have low correlations to the market. Can you give an example and how you came across an idiosyncratic distressed investment?

A great example of this is our position in Genco Shipping. Shipping had been on our radar for the past several years, as the industry has been distressed since the financial crisis, but has not had that much bankruptcy. Much of the shipping reorganization was pushed off, since the banks that lent to the industry were primarily European banks that were incentivized to avoid foreclosure. These banks opted to kick the can down the road to avoid having to mark the underwater debt to market.

When we first started looking at Genco in April of 2013 when its bonds were trading in the low 30s and the bank debt was primarily held by the Norwegian bank DNB. We were alerted to a pending restructuring of Genco in December 2013, as much of the bank debt changed hands and was purchased by a group of large hedge funds including Centerbridge and Apollo. These trades were rumored to have been priced in the low $90’s as broader market fundamentals were improving and shipping rates were on the rise. We took the view that these funds would not waive further covenant violations and had purchased the bank debt with the objective of forcing bankruptcy and owning the company. Genco had a $125 million convertible bond that we felt would have a blocking position in any restructuring.  We began purchasing bonds and set up a hedged position with a short in the equity. There was a clear mismatch between the debt & equity as we were buying the bonds in the 40s and shorting the stock at market cap of $90M. The catalyst for this position was a violation of the company’s bank debt covenants, which led to a reorganization and equitization of most of the liabilities. We sat on the creditors group in Genco, and were involved in the reorganization as a signatory to the Chapter 11 Plan Support Agreement. The plan of reorganization resulted in a conversion of the company’s debt into equity with a token recovery for the equity and a near par recovery for the bonds.

Conversely, you wrote about Exact Sciences as an equity short in your September letter and how it was the first name you published on when you were at UBS. That was 10 years ago. When do you decide that you know a company well enough to put your money into a thesis?

It depends on our comfort level and prior familiarity with an industry or particular company. There are situations in which we will do our initial work and initiate a small position that same day. That being said, we tend to wade cautiously into most situations. If something is appealing based on our preliminary research, we will take a smaller position while continuing to hone our thesis. If we increase our level of conviction as we do further research, we will increase sizing in accordance with liquidity and our view of the balance of risk and reward. It was easier to get comfortable with the Exact Sciences situation, as it is a company we have followed for over 10 years. Prior to initiating the short in Exact Sciences, we did a thorough “refresh” which included reaching out to physicians in the oncology field and having several conversations with the sell side. We confirmed our view that Exact was significantly overvalued and proceeded with our short.

You’ve written about sitting on creditors committees and the informational advantage that it provides. What is unique about how you sort through the information, and misinformation, that often comes as part of the Chapter 11 process?

Any given bankruptcy docket is filled with thousands of documents, the vast majority of which are noise and pertain to administrative matters. We think that as a starter, it is important to understand which documents are key. We always look at a company’s MORs, PORs, SOFAs, Disclosure Statements, 2019s & First Day Declarations. Services such as Reorg Research http://reorg-research.com/ have greatly improved the ability of a buy side firm to quickly monitor the docket and isolate important items. 

Sitting on a bondholder group or committee is an important step to being at the center of information flow. Having access to the attorneys and advisers involved allows us to get a great sense of how the chapter is proceeding and better understand the motivations of the various constituencies. We also closely watch 2019s and try to get a sense of who owns what and the extent to which they will defend their positioning. We think that having knowledge about the distressed firms involved is very helpful when trying to assess how a situation will play out. 

Recently there have been many market corrections and large drops in bonds as a reaction to only marginally weak earnings, and distressed investors are starting to see more opportunities. What is your prediction for the next significant distressed cycle?

We are of the view that we are closer to a turn in the credit cycle and the next wave of distressed investing opportunities. It is challenging to handicap the exact timing, but there are a number of signs that indicate that a turn is approaching.  There have been huge inflows into credit-related mutual funds driving a gradual move to tighter and tighter levels. More PIK Holdco notes were issued in 2013 than ever before, and this trend has continued into 2014.

We think that an eventual rise in interest rates will likely be a key catalyst as we have seen many poor companies able to refinance their liabilities in what has been a hot market for high yield new issuance. Just this morning I read the following headline on Bloomberg: “The $400 Billion Bond Mismatch Keeping Bears at Bay Endures”  The article mentioned that JP Morgan research is predicting fixed income “demand globally will outstrip supply by about $400 billion”.

New Issuance is ultimately purchased by mutual funds who have to buy to keep up with their inflows. Higher rates will make it more challenging for companies to continue to service and roll their liabilities. We anticipate and look forward to an associated uptick in the corporate default rate.

From an investing perspective, we believe that many distressed funds have spent the past few years focused on Lehman and the vintage of 2007 LBO’s (TXU, Caesar’s, Clear Channel, etc.). We anticipate that the downturn in credit will create opportunities in smaller capitalization companies with structures smaller than $3B. We think these smaller companies will find it harder to role liabilities than their larger peers. Advantage considers middle market distressed to be our “bread and butter,” and we think that the next cycle will be provide great opportunities for us to deploy capital as we grow our firm.

Are there people, events, things that have particularly influenced you as an investor?

Sitting on the trading desk at Xaraf Management (a trading group within Paloma Partners) in the crash of 2008 was a key experience in my professional development. It provided a perspective on just how bad things can get and how to approach trading in an illiquid cash bond market. The lack of liquidity magnified the degree of pain in the market as bids completely dried up. Those who were well capitalized were able to put on positions with great expected return and low risk, but most participants were too shell-shocked to be in a position to make investments. At Xaraf, we had done well in the market crash and were able to put on low risk basis trades that took advantage of the liquidity and leverage mismatch between cash bonds and CDS. I was also able to put on several low risk credit related risk arbitrage positions. During the crash, I saw the value of having dry powder when most don’t.

At Xaraf, I sat alongside and worked for Paul Pizzolato, who taught me the virtues of patience, position construction and sizing, and the value of liquidity in a down-market. I developed many skills at Xaraf, including unique approaches to merger arbitrage utilizing CDS and cash bonds to better optimize and hedge equity positions. Oftentimes, I would make the case for an investment and Paul would suggest that we wait and see if it gets cheaper. Many times it would, and we would find a far better entry point, which had a significant impact on returns. I have learned that there is a huge universe of potential investments, but the timing of entry and exit is critical regardless of thorough research and analysis. I learned the importance of being patient and waiting for the fat pitches.

At Wexford Capital I had exposure to Charles “Chuck” Davidson who was the right hand man of Michael Steinhardt for several years. Hearing Chuck’s perspective on investing and the experiences he had in the crash of 1987 had a lasting impression.
           
Can you talk about one idea you find particularly compelling today?

We think there is great upside to the bonds of the distressed Apple supplier GT Advanced Technologies, GTAT. GT has $434 million of convertible debt outstanding across two issues; a 2017 and 2020 both trading at 40. The company filed for bankruptcy on Oct. 6 in order to preserve value for creditors rather than continuing to hemorrhage cash as they attempted to fulfill the terms of an onerous contract to supply Apple with sapphire glass for the iPhone 6.

We believe there are sources of value that will drive recovery for the GTAT bonds. GTAT has significant cash, working capital, and the company’s SOFA filed on 11/21 disclosed that GTAT recently received a tax rebate of $29M.

Apple and the Company have reached a settlement which is pending confirmation by the court. An ad hoc group of creditors (of which we are a member) have filed an objection to this settlement as we believe it does not sufficiently repay the Company for the time, energy and money which was spent trying to perfect the Sapphire facility. The bonds could appreciate significantly if Apple agrees to recut this settlement with improved terms for GT Advanced.

One of the key ambiguities in the GTAT case surrounds the basic capital structure concept of “structural seniority”. The convertible bonds of GTAT sit at the holdings company and lack subsidiary guarantees. Funds from the issuance of the convertible bonds ultimately flowed down the capital structure from GT Advanced Technologies Inc. (“HoldCo”) to the various operating entities. There is approximately $125 in trade debt at the operating entities. A key question amongst investors and an ultimate driver of recovery will be the extent to which the Bonds have an intercompany claim that would make them pari-passu with some of the trade debt. We are of the view that at a minimum there is a strong legal argument to be made for substantive consolidation at the various GTAT entities. This argument was further coalesced on November 12th at the 341 meeting of creditors when it was disclosed that GTAT did not have a bank account in the name of the holding company and the proceeds of the convertible issuance went directly into the bank account of GTAT Corporation, an operating subsidiary.

We value the bonds at 60-70 in our base case scenario in which the court confirms the Apple Settlement. The settlement caps Apple’s claim against the company at $439mm and limits the claim to an operating company can that will sell the furnaces used for sapphire production. We model in $50M of value flowing back to the estate from the sale of furnaces. We value the core GT Advanced Solar businesses at $300mm.